What is Derivatives market

A derivative is a product, whose value is derived from the value of an underlying asset. The asset can be equity, index, forex or commodity. A derivative instrument does not constitute ownership, but is a promise to convey ownership. The mother of all derivative trading is forward trading, which dates back to 12th century.

TYPES OF DERIVATIVES
There are six types of derivatives.
1.Futures
2.Options
3.Swaps
4.Leaps
5.Baskets
6.Swaptions
Presently we are concerned with only the first two namely
the Futures and options.

What are Forward Trades

Forward trade is an agreement between two parties to buy or sell an asset, on a specified date at a specified price.
The terms are traded bilaterally.
The classic example being a wheat farmer forward selling his produce at a known price in order to eliminate price risk.
Conversely, a bread factory may want to buy wheat in forward in order to plan production without the risk of price fluctuations.
This is an useful tool for both, to hedge their risks.

What are limitiations of Forward Trade

As the forward contracts are traded bilaterally and there is no organized exchange, the following limitations exist.

  • Lack of centralized trading – You have to find Opposite Party for trading.
  • Illiquidity – You may not find opposite party for reverse trade.
  • Non standardization – No standard size of contract.
  • Counter-party risk – Other party may not honour the contract.
  • Due to all these limitations, there was birth of future contracts.
Birth of Future Contract
To eliminate limitations of forward contracts, in 1848, Chicago board of trade (CBOT) was formed to provide centralized location for such trades.

In 1865, CBOT listed the first futures contract. In 1919 Chicago Mercantile exchange (CME) was recognized to allow futures trading.
CBOT & CME remain the two largest futures exchanges in the world.
The most popular and heavily traded futures contract is based on S&P 500 Index.

FUTURES CONTRACTS
  • These are centrally traded in an exchange and you need not know the opposite party.
  • These are standardized in terms of market lots and expiry dates.
  • These are highly liquid.
  • No counter-party risk as the clearing corporation assumes the risk.
  • Not necessary to hold until maturity or expiration.

Advantages OF Futures Contract

  1. These are centrally traded in an exchange and you need not know the opposite party.
  2. These are standardized in terms of market lots and expiry dates.
  3. These are highly liquid.
  4. No counter-party risk as the clearing corporation assumes the risk.
  5. Not necessary to hold until maturity or expiration.

A futures contract holder assumes rights as well as obligations to honour the terms of the contract.
The futures contracts can terminate into delivery or can be offset by entering into opposite trade. 99% of the futures contracts do not result in delivery.
In India, mainly we have index futures on the BSE Sensex and the NSE Nifty.
Also we have individual stock futures.

What are Expiration, Series & Basis in Futures Markets

EXPIRATION
In Sensex and nifty futures we have three monthly contracts running at a time. Current month and next two months. They are identified by the calendar months like June futures,
July futures, August futures etc.
Last day of futures contract is know as expiration date. Sensex and Nifty futures expire on last Thursday of every month (or previous day if Thursday is a holiday) and from
the next trading day, a new month contract starts.

SERIES
A futures contract belongs to a particular series. One series belongs to a particular month.
E.g. Nifty index futures series for April or May etc. Nifty series is coded as below –
FUT IDX NIFTY 24-April-2008 Here, not only month, but expiry date is also available.
Sensex series is coded as below : BSX APR 2008

BASIS
Basis = Spot price – futures price.
In normal market, basis is negative, i.e. futures price is greater than spot price. Negative basis reflects upward expectations about the market. In inverted markets, Basis can be positive i.e. futures price is lower than spot price. Positive basis reflects downward expectations about the market. Basis can be positive in commodity markets, where commodity is in short supply and hence spot price is high.
What is Open Interest
The futures market is a zero sum game. Total numbers of longs in the market are equal to the total number of shorts.
The total number of outstanding contracts (which have not been closed) long/short at any point of time is called ‘Open Interest’.
Open Interest is normally maximum in near month expiry contract.

OPEN POSITION
Open position in futures of a stock exchange member is calculated as follows :
Net position of proprietor + Gross position of client = Open position of broker.
Open positions for proprietor and clients are calculated separately.
For Proprietor: -
Buy Qty – Sell Qty = Open position.
If Buy Qty > Sell Qty, then open long position.
If Sell Qty > Buy Qty, then open short position.

For Clients: -
First, long and short positions for entire client pool are calculated separately.
Clients (Buy – Sell) = Clients long position.
Clients (Sell – Buy) = Clients short position.
Now member’s open position = Proprietary net position + Clients long position + Clients short
position.
Futures Trade Billing & Billing On Expiry dates
Futures market involves every day Billing. Every trade is Billed by closing price for the day as counter- price. In this way, closed trades are billed and also open positions are billed on mark to market at closing price for the day. Now today’s closing price becomes reference price for the
next day.

BILLING ON EXPIRY DATE
Here all open positions will be squared at closing price of the spot market. Hence actual profits earned or losses incurred on closed trades as well as open positions are settled on day to day
basis. These are to be paid to the exchange on T + 1 basis.
Margins & Voilations
Margins are calculated on VAR ( Value at Risk ) basis.
The amount will be large to enough to cover a one – day loss that can be encountered on 99% of days, depending on the volatility of the stock or Index. Initially SEBI has stipulated 5% minimum margins. Stock Exchanges can impose higher margins. Trading members can also impose higher margins on clients. The margin will depend on the risk profile of the client and
delay in funds transfer in banks.

Maintenance Margin is typically 75% of Initial Margin.
When margin falls below Maintenance margin. Margin call is made to restore it to Initial Margin.
Margins to be imposed on clients will depend on
  • Price Volatility
  • Daily Circuits, if any
  • Time needed to recover additional margins
  • Traders objectives
  • 1. Day Trading – Less margin
    2. Calendar Trading – Less margin

If margins are not received in reasonable period, contract can be closed out.

VIOLATIONS

  • Initial Margin violation
  • Mark to Market value violation
  • Contract position Limit violation

Initial Margin violation
Liquid Net worth of trading member = Deposits with NSE – initial margin at any point of time.
Liquid net worth of Rs 50 lakhs always to be kept with exchange. Say total deposits are 80 lakhs, till such time that initial margins are upto 30 lakhs, there is no problem. But if the exposure increases and initial margin goes to 31 lakhs, it is a violation.

Mark to Market value violation
The mark to Market value of CM, across contracts, is monitored intra-day. At no point of time should the mark to market value of all open positions of a clearing member be greater than liquid net worth 33 1/3 time mark to market value.
Contract position Limit violation
Limit on trading members open position. Higher of Rs 100 crores or 15% of open interest in the nearest month. Any crossing, even on intra-day basis shall be a violation.